Notes from the road: Serbian fixed income in the spotlight

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Key takeaways

The National Bank of Serbia (NBS) is doing a creditable job on monetary policy and financial stability. We are constructive on the outlook for inflation and believe the NBS has cemented its credibility in terms of anchoring medium-term inflation expectations. Exchange rate stability remains a key pillar of NBS monetary policy.

Fiscally, the government has achieved an impressive adjustment with an 8% of GDP structural improvement in just three years, providing fiscal room for 2019. We believe an increase in environmental protection investments should be a top priority for the government.

Growth expectations have been revised up to over 4% in 2018. The major challenge now becomes how to boost the potential growth rate of the economy.

The Serbian dinar is well supported by the macro fundamentals and we expect moderate currency appreciation in the medium term.

The risk-reward of Serbian government bonds remains attractive. We remain invested.

Some changes at the Public Debt Administration (PDA) require careful monitoring.

A positive economic picture

In the first half of 2018 the economy shifted up a gear as GDP growth reached 4.9% and 4.8% year on year in the first and second quarter, respectively. Households final consumption grew at the fastest pace since the global economic crisis of 2008. Domestic demand was further supported by continued double-digit growth in gross fixed capital formation. The IMF resident representative revealed the Fund’s intention to revise up its estimate of economic growth for this year to 4.2% from 3.5% with the risks skewed to the upside.

Employment growth remains positive, despite a shrinking public-sector workforce, due to significant employment gains in the IT and manufacturing sectors. Meanwhile, during an official visit of President Vučić in Beijing in September, new agreements with Chinese companies estimated at USD 3 billion were announced.

Impressive fiscal consolidation

On the fiscal side, we expect another solid surplus this year

On the fiscal side, we expect another solid surplus this year, following a remarkable structural fiscal adjustment of 8% of GDP in just three years. The composition of the public debt has improved significantly in terms of maturity as well as currency denomination, while the interest rate bill has come down faster than anyone expected.

The public debt-to-GDP ratio is on a clear improving trend expected to drop below 60% this year. Significant progress has also been made with respect to the restructuring of public enterprises and privatisation of state-owned enterprises. It looks increasingly likely that the budget for 2019 will comprise a sufficient fiscal space provided by economic growth, decrease of public debt and the final payment of the debt of Srbijagas from the budget.

During our meetings with policy makers our message was clear: the government should not repeat the mistakes from the past when favourable fiscal trends were used up for populist measures. There are pressing needs that require a strong increase in public investments. Based on analyses conducted by the independent Fiscal Council, the need for the construction of wastewater treatment plants, drinking water factories, expansion of the sewage network will require an increase in budget expenditures for environmental protection to about 1.2% - 1.4% of GDP.

The battle against inflation has been won

As inflation remains comfortably below the 3% mid-point of the target band, and in view of stable inflation expectations, the central bank has kept its key policy rate on hold at 3.0 % since its last reduction in April. Core inflation remained low and stable in September at 1.1%, unchanged from the previous month. It is worth noting however that low inflation and inflation volatility is a relatively recent phenomenon in Serbia.

The economy has previously experienced long periods of double-digit inflation. In our meetings at the National Bank of Serbia, the Governor referred to that deep fear of hyperinflation in the public’s mind coming from the past. Due to the high penetration of the euro in the Serbian economy, the NBS had to establish a stable exchange rate first. This immediately led to much lower inflation and inflation volatility. Equally important in the fight against inflation was the coordination of monetary and fiscal policies.

Equally important in the fight against inflation was the coordination of monetary and fiscal policies.

‘Dinarisation’ process ongoing

NBS Governor Tabaković outlined that the next step for the Bank, after taming inflation, would be to speed up the ‘dinarisation’ process of the economy. According to NBS, a more extensive use of the dinar in the financial system, and better currency matching of income and expenditures of the non-bank sector would improve the country’s financial stability, lessen the risk of exchange rate volatility in the most vulnerable sectors of the economy and reinforce the effectiveness of monetary policy.

The Serbian dinar’s share of savings is growing but remains low. A necessary but not sufficient condition for the success of the dinarisation process is maintaining exchange rate stability. NBS understands well, however, that sending a strong and credible message to the public on the benefits of dinar deposits, including higher interest rates and a favourable tax treatment, is essential. Equally important in our view, is improving secondary market liquidity and allowing market participants and investors to hedge currency risk.

Financial stability

The financial sector is in good shape following the massive reduction in non-performing loans (NPLs) since the peak of the financial crisis. The NPL ratio, currently at 6.7%, has dropped by 60% since the adoption of NPL Resolution Strategy in August 2015. There are twenty banks operating in the country of which twenty are foreign-owned. The top five banks have, on aggregate, a market share of 55%. The capital adequacy ratio currently stands at 22.9% much higher than the 8% regulatory level. Liquidity indicators are almost double the regulatory levels. Profitability of the sector has also improved significantly last year with 25 of 28 banks recording profits.

Closely monitoring the new Minister of Finance

The new Minister of Finance, Siniša Mali, former mayor of Belgrade, has big shoes to fill following the impressive results achieved by his predecessor Dušan Vujović. In a recent interview, Mr Mali appeared committed to reducing public debt further: “… most important thing is for the public debt to drop below the level of 50% of the GDP”. We were surprised, and somewhat concerned, by the decision of the new minister to replace some very experienced staff at the Debt Management Agency who had won investors’ trust over the years with their pragmatic and transparent debt management.

Conclusion: positive in the main

Although keenly mindful of the concerns outlined above, in the main we remain constructive on Serbian bonds and currency. Macroeconomic stability in an environment of structural reforms and full coordination between monetary and fiscal policies is delivering results reflected in low inflation, accelerating economic growth and employment as well as a fall in the country’s risk premium. The sustainability of good economic results should not be taken for granted, however. As Mr Vujović put it “We must resist the temptation of following the pressures of popular demands that may draw the reform ship to the Charybdis rocks and destroy it”.

Important information

This material is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual results may differ materially from those stated herein. All rights reserved. Issued by Investec Asset Management, issued October 2018.